Options are legally binding agreements that grant the holder the right, but not the obligation, to buy or sell a financial instruments (i.e. commodities like crude oil, cotton, and wheat) on a particular date some time in the future at a set price. Options contracts generally have standard quality, quantity, delivery time and location depending upon the type of underlying commodity associated with them. The only “negotiated” variable is price (or “premium”), which has traditionally been discovered on the floors of futures exchanges, such as the Chicago Board of Trade through the open outcry auction market system. This process allows buyers and sellers to consummate trades by offering verbal bids and offers.
Certain terminology is essential in the field of option trading. A CALL is the right, but not the obligation to buy, for instance, an underlying commodity at a specific price (strike price) up until a specific time in the future (expiration date). A PUT is the right but not the obligation to sell the underlying commodity at a specific price up until a specific point in the future. A CALL SPREAD is when you simultaneously buy one call and sell another. An example would be the simultaneous buying of a May 50 call and selling of a May 55 call. If they were in different months it would be a known as CALENDAR CALL. This is a spread which would be the simultaneous buying of a May 50 call and selling of a July 50 call. A STRADDLE is the simultaneous buying of a call and a put of the same strike in the same month. So one would be buying say, a 50 call and buying the 50 put. Another trade type is a FENCE, which would be the simultaneous buying of a put and selling a call (or selling the put and buying the call). If one executes these trades in different months it is a “calendar” fence. Many option trades are carried out by combining multiple calls or puts in various different combinations (such “multi-leg”). Other trading types have colorful names such as butterflies, strangles, calendar spreads, Christmas trees, condors, iron butterflies, etc. each involving different trading strategies. For instance, a BUTTERFLY is the sale (purchase) of two options with the same strike price, together with the purchase (sale) of one option with a lower strike price and one option with a higher strike price. All options must be of the same type (call or put), have the same expiration date and, there must be an equal increment between strike prices. Some types of options trades and strategies could have even say 12 legs. Every trade or option strategy is just a combination of calls and puts and one must have an understanding of each option type—its pattern and how many legs it would have.
The open outcry system allows for quick assimilation of market information where buyers counterbalance sellers and ultimately arrive at a fair market value for the contracts. However, the open outcry system does not always provide for price transparency—making it difficult for some consumers to directly participate in the process. Furthermore, as the volume and volatility of the futures market continues to increase, it is becoming more difficult to handle the administrative challenges presented by the open-outcry system. For these reasons, among others, there is a need for a different approach to options trading.
One potential solution is the use of an electronic order entry system. However, unlike open-outcry, traders in a computerized setting cannot “see” the market participants; “feel” the interest in a particular instrument. Thus, there is a need for an electronic order system that provides human market participants with the feel of an exchange floor with the convenience of computerized organization.